Investor confidence is an elusive, fragile thing but as the traumatic roller coaster ride in the markets this week makes clear, without it, the whole financial system risks turning to dust.
The failure on Monday of United States investment bank Lehman Brothers, then the emergency sale of peer Merrill Lynch and the US government rescue of giant insurer AIG wiped hundreds of billions of dollars from the stock market.
The $85-billion bailout of American International Group was especially damaging to confidence, with the government saying it had to take the unprecedented step for fear its bankruptcy would cause untold damage to the US financial system and economy.
That bailout twisted even tighter the credit crunch at the heart of the current turmoil, with banks in need unable to find fresh funds while their counterparts who had cash, refused to lend it out for risk of more losses.
“It seems like the money that used to be around has disappeared but it hasn’t disappeared, it’s just being held back,” said Jan-Egbert Sturm, director of the KOF Swiss Economic Institute.
To escape the impasse, the central banks poured hundreds of billions of dollars into money markets in an effort to head off another failure that could have completely destablised the global financial system.
“There is extreme discrimination now; some banks have to pay sharply higher interest rates to get money, some don’t get any money at all. It’s a systemic problem that only central banks can solve,” Credit Suisse analyst Marcel Thieliant said.
By Thursday, reflecting the issues at stake, the amounts involved had become huge — the US Federal Reserve offered $180-billion to relieve “elevated pressures” in global markets and promised another $50-billion.
The Fed was also joined by the European Central Bank along with Britain, Japan, Switzerland and Canada in offering to swap currencies for dollars, taking the total to more that $300-billion.
Not only was the sum colossal, the fact that central banks such as Canada and Japan, which normally release liquidity in their own currencies, were releasing liquidity in US dollars, was significant.
“The most important thing about this coordinated action is that there is access to US dollars even when the US markets are closed,” said Thieliant.
This means that foreign subsidiaries of US financial institutions, for instance, could get access to US dollars at all times.
In this way, the central bankers around the world this week stood as lenders of “last resort”, making available the funds necessary to save the wider financial system when no one else could.
Sturm emphasised how important the issue of confidence is to the process.
“At a time when the issue of trust and confidence is of utmost importance, it does not help to let other banks or investors know that one is turning to the [US] Treasury for funds. By offering US dollars around the world, it makes it easier for banks to circumvent this problem,” Sturm said.
On Friday, news of a US government plan to cordon off the toxic debt and dead housing loans at the root of the current problems saw stock markets soar around the world.
There were massive gains in the banks as investors looked for bargains among the beaten down financials, reassured that the US and other governments would now do what it takes to stop the rot.
The bill, however, will not be small for this return of confidence.
“We’re talking hundreds of billions,” US Treasury Secretary Henry Paulson said in Washington ahead of more talks on the US rescue plan.
“This needs to be big enough to make a real difference and get at the heart of the problem,” he added.
Analysts welcomed the move but cautioned that it is too early to sound the all clear given the massive damage already done to the financial system.
“The financial crisis is, however, not yet over,” Unicredit economist Nikolaus Keis said.
“The risks remain high. The Damocles Sword of a credit crunch is … hanging over the US economy and the risk of recession is still with us.” – AFP